The past year has been rough for the mortgage sector. The Federal Reserve has been hiking rates aggressively, which has dented mortgage-backed securities (MBS) valuations, and mortgage originators have struggled with declining volume. Mortgage-backed securities -- bundles of mortgages combined to form bond-like securities -- have underperformed Treasuries and are the culprit behind some of the regional bank failures. Two Harbors (TWO 0.14%), a mortgage real estate investment trust (REIT), recently reported a large loss and offered investors few assurance that things will get better anytime soon or that its sky-high dividend -- which it just cut -- is safe from further reductions.
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Two Harbors's dual strategy
Two Harbors is a mortgage REIT that invests in mortgage-backed securities and mortgage servicing rights. Mortgage-backed securities are basically where most newly originated mortgages go. If you bought a house last year with a Fannie Mae or FHA loan, chances are your mortgage ended up in a mortgage-backed security, which might in turn have ended up in a mortgage REIT's investment portfolio.
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Key Data Points
Mortgage servicing is an unusual asset
Mortgage servicing rights are one of the more unusual assets out there. A mortgage servicer performs the administrative tasks of handling a mortgage on behalf of the mortgage investor. The servicer sends out the monthly bills, collects the payment, ensures property taxes and insurance are paid, and works with the borrower in the event of default. The servicer is paid 0.25% of the mortgage principal per year to perform this service. For a $400,000 mortgage, the servicer receive about $1,000 a year. The right to perform this service is worth something, and it is capitalized on the balance sheet as an asset.
Mortgage servicing rights therefore throw off a lot of cash, and they have an unusual characteristic -- they increase in value as interest rates rise. Most assets decrease in value as rates rise. Two Harbors uses mortgage-backed securities and servicing as a way to hedge each other. If interest rates fall, the mortgage-backed security portfolio will go up in value, but the servicing valuations might decline in value. When rates rise, the mortgage servicing portfolio will increase in value while the mortgage-backed security portfolio falls. Over the past year, mortgage servicing has carried a lot of mortgage REITs and bankers.
Interest rate volatility increased in the first quarter of 2023
Last year, mortgage-backed securities fell in value as interest rates rose. Not only that, but mortgage-backed securities really react poorly to interest rate volatility, and the Fed has yet to end one of the most aggressive rate tightening cycles in history. To make matters worse, volatility ticked up markedly during Q1 as higher-than-expected inflation data in January and February drove up rates up, which then reversed quickly with the collapse in March of Silicon Valley Bank and the spreading contagion to other regional banks.
Banks are selling mortgage-backed securities
The regional banking turmoil added another headwind for the mortgage sector: Additional supply. The Federal Deposit Insurance Corp. (FDIC) is liquidating the portfolios of several failed banks, and this phenomenon is being met with reduced appetite for mortgage-backed securities. The Fed which used to be a big buyer during the days of quantitative easing, is no longer much of a player. Banks, bond funds, and mortgage REITs are the main buyers left, and they are moving cautiously.
Ultimately this will benefit the mortgage servicing portfolio, but at the expense of the residential mortgage-backed securities (RMBS) portfolio. On the plus side, weak mortgage pricing leads to higher mortgage rates, which makes refinancing unlikely. Refinancing waves are the enemy of mortgage servicing rights. The company envisions low to mid-teens returns on the RMBS portfolio going forward.
Two Harbors didn't come close to covering the dividend in Q1
This brings us to the dividend. Two Harbors recently cut its dividend from $0.68 per quarter to $0.60, though with the stock's decline the yield stands at more than 19%. That should mean the dividend cuts are done, right? Well, earnings available for distribution in Q1 were just $0.09, which was way short of enough to cover the payout.
The company was asked about the dividend on the earnings conference call. Two Harbors Chief Financial Officer Mary Riskey pointed to a slide in the earnings presentation that envisioned a metric called Prospective Quarterly Static Return Per Basic Common Share (basically applying the return assumptions to the portfolio), which would be anywhere between $0.50 and $0.69 per share.
Is the dividend safe? No. The company might be able to cover it, but as a general rule companies also like to have some breathing room, and it looks like Two Harbors doesn't have much. As a general rule, when mortgage REITs have dividend yields in the high teens, it is usually an ominous sign. On the other hand, Two Harbors is trading at a 25% discount to book value per share, which indicates the market sees book value per share continuing to decline.
Two Harbors needs a lot of things to go right, and investors stepping in now risk another dividend cut. Two Harbors is a speculative bet and probably too volatile for an income investor's portfolio.
